I have heard across the debt market that APRA has made two small but significant changes to how banks manage securitisations via APS 120. This may just kill Australian Lending FinTech.

End of Fintech

Two adjustments to the regulatory guidance have created new issues for those looking for warehouse financing or securitisation capability:

  1. APRA will limit any tranche retention in a securitisation to 20% notional of a senior tranche. In other words, a 20% senior exposure cap on what a bank can retain in a securitisation. There is a particular focus here because APRA doesn’t believe retained senior AAA and selling junior mezzanine tranches is a suitable risk transfer (ie. capital relief securitisation is not suitable).
  1. There is a loan warehouse growth cap of the lower of a bank’s investment home loan growth and the 10% APRA cap applied to investment home loans.

Major issue:

This will significantly impact all Lending FinTech at a later stage. I can’t see anyone scaling without either a banking licence or securitisation or probably both.

Funding Growth:

Lending FinTechs don’t have direct access to deposits, so if they want to scale and be cost effective, their only options are to tap into capital markets or other lenders’ balance sheets. And the most cost-effective way to do this is through bank warehousing facilities or loan securitisation. Further:

No “Unicorn” Lending or P2P FinTech exists (with the exception of RateSetter) without a publicly announced securitisation program.

See our table if you need further evidence:


Latest Valuation (USD) Securitisation Name


$1bn+ KABB


 $1.9bn+ CHAI
Funding Circle  $1bn+


Avant Credit

$2bn+ AVNT




OnDeck  $1.5bn


Lending Club  $7.2bn*


Zopa $760m+


Given lack of local Australian senior tranche or AAA buyers via capital markets (just 8% of super fund assets goes into non-bank fixed income, source: OECD), FinTechs would be forced towards the 4 Aussie majors. Overseas wholesale is just too much for a young local FinTech with a local product, plus currency swaps are an extra cost and complexity.

But now a growing FinTech cannot obtain funding from a major bank, as the capital relief type securitisation is now blocked. And don’t think you can try to run a book with 10 different senior tranche investors: new deals need to be especially “clubby”.

What about warehousing?

Warehousing is another option that will be constrained, although if there is not going to be a longer term securitisation market, the demand for warehousing might also fall. Warehousing is a stop-gap: helping non-banks get to scale before a securitisation. If this is now capped, then FinTech growth is now capped. I would also expect Australian banks to service existing clients with scale over high growth yet still small FinTech who might have longer-term payoff.

What Else? No deposits. No Collaboration.

Looping back, APRA has not showed any a desire to open up access to banking licences to FinTech (ie. direct deposit access) and the Federal Government has not got the appetite to provide support in the same way as the UK government did via buying loans or credit guarantees.

This, coupled with a low appetite for banks to engage with FinTech, has made life significantly harder.

What’s left?

In my opinion, not much. Small FinTechs with small warehousing facilities may exist but the ability to scale has now gone. Overseas FinTechs, who have already scaled, can come and then distribute securitisations given the bigger brand name and their local markets, notably the US, China and Europe.

Now APRA will have other reasons for its actions, so this isn’t a criticism of them. They need to manage Australia’s banking system. But this current approach appears to be pushing against where other global regulators and governments are going.

As it stands, the point of Lending FinTech was to bring technology and data into finance, which includes risk management and credit scoring processes for better borrower outcomes. This would push major banks harder, increase competition and, ultimately for Australians, create a financial services industry that we can export globally in the same way we consume a huge amount tech from Silicon Valley technology companies.

But it looks like APRA has now taken the Tech out of FinTech.



*We all know about Lending Club’s struggles over the last 2 years.

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Beating the Robots


As a FinTech founder and mathematician, I should probably favour algorithms over human assessment. I often do. However I am getting tired of hearing about yet another algorithm that is able to predict, forecast and act on data to make financial decisions. Ultimately we’ve seen it before. Will the algorithms and robots win or does human analysis shine through for another business cycle?

This story starts with a cornerstone of basic AI and automated credit decisioning. Algorithms are built that take a lot of consumer data and perform analysis called logistic regression to develop a “good-fit” model. The observed data is then used to produce an equation that prescribes an expected behaviour. For lending, this is a probability of default forecast.

My first skepticism is due to my mathematics background. I loved engineering mathematics and fluid dynamics, when pure mathematics is used to derive equations that are fundamental to the development of aircraft, cars and all kinds of other high technology equipment we have today.

This mathematics saved time: a single equation developed through algebra meant we had ways to describe what would happen. The human mind equipped with paper was able to forecast without calculation.

As time went on, computational ability improved. In non-linear dynamics, we became interested into when and where systems went from calm to chaos. In effect, we wanted to know when our derived equations became unstable. Computational methods appeared that were able to map out these cases and build up smart eco-systems which then formed a more accurate forecast of reality than the human generated equations.

In the 1970s we started applying the initial human derived models without computational power to start predicting really annoying things like traffic jams. Over time, computers were introduced and we learnt that the computational part was much more influential that the initial models we derived: the human equations mattered less than the rapid ability for a computer to estimate all the potential ways the system would break down into a traffic jam – and then alleviate those risks. My last piece of research on this was in 2005 and computer power has move on exponentially.

Then in 2006 I did what all reasonably good engineers did: I went to work for Wall Street. Same equations and a real application of the mathematics (I failed to mention that the traffic jam research was mostly focused on driverless cars, something that will take another decade to become mainstream). Correlations, causations and logistic regressions where everywhere. In fact there was an attractive mix of human-built equations and computer generated ones. But the data source was bad: a long stretch without a recession and notably no significant house price corrections meant the instability was never tested. We know what happened next.

Moving forward to today, we see far less human developed equations. In any case, they have become far too complicated for many and I believe the variation of data in the world is significantly more important than the fine-tuning of the human equations, just like the traffic jam models.

But my concern now is about asking if these models are correct this time round? Can we trust the goodness of fit? Are sufficiently good stressed data sets used? Are people caring about the what-ifs? In my mind, the opportunity to beat the algorithms and robots is just as relevant as ever:

  • Australian banks view investor loans as less risk than owner-occupier loan. The data they use shows this. International evidence suggests this is not the case.
  • Data shows that SME lending is not worthwhile (and many banks have pulled back from this). But have they missed out on how new relationships can be formed or more suitable products can be developed.
  • Banks continue to adore their credit card businesses yet we all believe this rewards-based value capture will end at some point.

At the same time, we must also be aware that there will be human interference. Investor loans benefit from a tax break, SME lending will always be politically important and credit card use has been sticky.

The key to all this is not only capturing vast amounts of data but then finding ways​ that it can be effectively used to test your human or computer-generated equations but also how an artificially intelligent machine can adapt its equations when there will be known human interference, such as political and legislative changes.

This is how we can beat the existing robots.



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Australia’s Major Problem: The 4 Major Banks Are Stuffed Full


One key attribute of the Australian financial system that people need to know about is the reliance on the 4 Major Banks to fund the economy. The lack of wholesale markets, driven by local insurance and local superannuation funds desire to invest sub-investment grade credit or equity portfolios (as opposed to investment grade and AAA/AA/A securitisations), has led to a reliance on the 4 Major Banks to fund the economy.

This is most easily seen in the following tables:

Total Assets $AUDm as Per Annual Reports
30/06/04 30/06/05 30/06/15 30/06/16
CBA 305,995 329,035 903,075 933,078
WP 237,036 254,355 812,156 839,202
NAB 411,309 419,588 955,052 777,622
ANZ 259,345 293,185 889,900 914,900
4 Major Total 1,213,685 1,296,163 3,560,183 3,464,802
GDP (past 4 Qs) 1,190,000 1,229,000 1,617,000 1,658,000
As % of GDP 101.99% 105.46% 220.17% 208.97%


Lending Liabilities $AUDm As Per Annual Reports
  30/06/04 30/06/05 30/06/15 30/06/16
CBA 205,946 235,849 674,466 700,547
WP 170,863 188,073 623,316 661,926
NAB 247,836 260,053 532,784 510,045
ANZ 204,962 230,952 570,200 575,900
4 Major Total 829,607 914,927 2,400,766 2,448,418
GDP (past 4 Qs) 1,190,000 1,229,000 1,617,000 1,658,000
As % of GDP 69.71% 74.44% 148.47% 147.67%

For the past decade, Major Bank balance sheets (both total assets and total loans) have grown, on average, at 10% CAGR (except NAB, which has been impacted by overseas businesses). These assets and loans are mostly domestic.

At the same time, GDP has grown at 3% CAGR in nominal terms, leading to approximately 7% higher bank balance sheet growth than GDP each year. The 4 Majors used to have total assets/loans at 100%/70% of GDP but now have 220%/148%.


At what point do the 4 Major Banks get full? How can the economy continue to grow at a strong level if the bank balance sheets can no longer grow credit above GDP growth as either deposit growth struggles to keep up or financial stability reduces given the high concentration risk of funding via such a narrow channel. Can this lead to a credit crunch? My view is that they may already be sufficiently full to prevent new lending at anything close to the rate experienced in the last decade (noting the below trend YoY growth in 2015/2016, albeit with NAB’s Clydsdale disposal making an impact).

Possible Mitigation

As a response, only a few alternative strategies are really available:

  1. Overseas Wholesale
  2. Local Wholesale
  3. Interest Rate Reduction
  4. RBA Funding (QE)

The 4 Major banks need to tactically grow overseas and local wholesale markets. Overseas distribution of securitisations, particularly the US market, has continued to be an available option but banks may need to consider how the pass fully desonsolidated deals into this market and what return requirements they are willing to take to facilitate this. Even if the 4 Major Banks don’t take the bulk of the spoils, the overall support this gives to the wider economy will lead to better outcomes for the 4 Majors. This may require supporting non-ADI Australian lenders, including FinTech, and identifying high-value opportunities in assisting these business. This may also lead to the development of broader local wholesale options.

Local wholesale potential is split between expanding the lending performed by insurance companies – which could be enhanced by regulatory changes – or by encouraging superannuation to take on a higher percentage of fixed income assets in their portfolios, particularly senior tranches of asset-backed securities. The obvious rationale: if super funds don’t support lending in Australia, there will be detrimental impacts to equity returns that make up the majority of their portfolios as net new lending is an input to economic growth.

Screen Shot 2016-11-16 at 13.54.22

An alternative approach will be for the RBA to buy financial assets. If a local securitisation market does expand, this could be supported by a form of QE. This would be inline with actions the US Fed took in buying agency RMBS or the ECB in corporate bonds.

The last option will be lower interest rates that may be linked with QE. Lower interest rates will support further credit growth and help banks manage a higher balance sheet level versus GDP. But note that interest rates are already low for an economy where the banks have mostly been well-run and capitalised.

Something has to happen

Without a system-oriented movement into addressing the runaway growth of the 4 Major Bank balance sheets, I would expect a major debt-driven problem to emerge in Australia within 5 years. This doesn’t imply a crisis at this point in time but does suggest an eventual fall in the rate that the economy can grow. If house price growth has been driven by credit expansion, this trend simply cannot continue without the financial system becoming top-heavy due to the 4 Major Banks’ balance sheets.

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Mortgage Rate Forecasting, January 2017 (Pre-Trump)

With the clock winding down to the Inauguration of US President Elect, Donald Trump, a quick update on Australian mortgage rate forecasting.

In the last 2 months we have seen most Australian lenders increase their home loan rates across their fixed products (2, 3 and 5-year fixed rates) and well as increases to variable rate products. This is inline with our prior forecast in November. Investor loans have had a higher hit, in part due to higher systemic risk, the APRA 10% annual volume increase limit (banks using price to temper strong demand), and simply less sensitivity to rate increases (it’s not going to stop investors given high house price growth and the ability to negative gear away some of the higher increase).

Based upon maintaining a margin above where the cash rate is expected to be (2.25% premium), the lowest discounted variable rates are, on average, expected to reach 5.70% within 10 years. This is an average case forecast with variation possibly up to 2% higher.

Screen Shot 2017-01-18 at 09.44.45

As we have discusses before, now is a great time to borrow with fixed terms for as long as possible as rates are low, the RBA is expected to consider interest rate increases (1 in 3 chance of a rate hike this year) and incumbent banks are increasing interest rates even without RBA rate changes. The cheapest variable home loans have already increased about 0.2% in the last 2 months.

We believe the best way to mitigate the risk of higher interest rates is by opting for one of our 10-year FlexiFix mortgages. The interest rate is fixed for 10 years but borrowers can repay, refinance anytime without break fees after 3 years. If rates don’t go up, go down or you feel more comfortable in being able to manage interest rate rises, then you can switch without facing any finance related costs from our side.

This can be done with a straight mortgage or with a split loan (part FlexiFix, part variable).

Other Forecast:

We will look at what happens to expected rates after the Presidential Inauguration. Many experts expect to see a few interesting changes over the next few weeks.

To find out more and be the first to obtain the loan when we launch, visit www.huffle.com.au

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Capital Floor Impact: Wholesale versus Retail


The latest thoughts on new bank capital rules are that risk-weight floors are introduced so that advanced banks are no longer able to significantly deviate from regulatory views on capital adequacy for credit exposures based on internal models.

Banks that have internal models have shown large discrepancies between institutions in how they view the same type of risk. So international regulators are considering making a few adjustments that cover this:

  1. Should large banks have a huge capital advantage over small ones? Diversification across much larger pools is a justification but there should be a limit.
  2. Should the maximum deviation be contained? For better prudential risk management would suggest yes. And this is most easily delivered by having a minimum limit on how little capital a bank would hold against a specific risk.

Minimum Levels: A Floor

This brings us to IRB Floors. Any internal ratings base bank will potentially be subject to holding capital based on the higher of:

  1. The internal view on risk
  2. A minimum percentage of the regulator’s view on the risk via standardised rules.

Advanced IRB banks show evidence to regulators as to why IRB models should apply – receiving regulatory approval for the probability of default and loss-given default based on historical evidence compared to the bank’s credit scoring methodology.

The Floor would then say that is OK as long as the bank isn’t stretching the capital too far from aggregate data gathered by regulators that forms part of its standardised one-size-fits-all view.

Statistical Error versus Conservatism

A bank may have experienced lower losses based on sampling rather than the real risk but someone has to be wrong or too conservative: just because a borrower takes a loan from a smaller bank rather than a Major bank shouldn’t mean they become vastly different in risk.

Minimum thresholds already exist in some cases and one was introduced by APRA for residential mortgages as a response to the Financial System Inquiry. This also happens in other cases, particularly for banks in FIRB status (halfway from being considered eligible for full internal ratings based status).

Back to Basel

Credit Rating

APS 112 (Standardised) IRB Capital 60% Floor 75% Floor 90% Floor


5.00% 2.12% 3.00% 3.75% 4.50%


10.00% 3.46% 6.00% 7.50%


BB 10.0% 6.27% 6.00% 7.50%


B 15.00% 9.91% 9.00% 11.25%


Returning to the Basel committee, there are 3 potential numbers being suggested for the Risk-Weight Floor: 60%, 75% and 90%.

Using 30% LGD and a 3-Year maturity, this suggests the following impact to corporate credit:

Basel III with a 75% RW Floor on Corporate Loans (LGD = 30%, Maturity = 3) increases the required capital on A and BBB loans significantly. If a bank cannot adjust the loan spread, then the return on capital will drop dramatically.

Given the 4 Major Australian banks hold $575bn in corporate credit exposures and assuming this is realised as an upfront loss of 1% (averaging the implied loss across all credit ratings), this will equate to destroyed value of $5.75bn if banks had to mark-to-market. Of course, as banks are hold-to-maturity this will be reflected in lower return on equity but the overall impact will be the same over time.

Credit Rating

Expected Spread @ 25% RoRC New Required Spread New RoRC (was 25%) Implied Loss of Value on Loan


2.06% 2.47% 14.13% 1.22%


2.44% 3.45% 11.53%


BB 3.37% 3.68% 20.92%


B 5.48% 5.81% 22.03%


Importantly: banks will have to absorb the cost for loans made in the past and new loans will have higher interest rates.

Residential Mortgages:

Within consumer lending, the 4 Majors continue to have a major pricing advantage due to the capital they hold versus all other banks. Standardised banks hold 35% risk-weight against sub-70% LVR loans (APS 112), whereas the 4 Majors are holding an average of 25% across the entire loan book.

Screen Shot 2017-01-06 at 09.31.02

The originally proposed and retracted 25% Risk weight floor would represent a 71% risk weight floor versus the standardized level (35% RW).

Clearly, we expect 60% to have limited impact whereas 90% would lead to a higher capital charge. Working through the 90% example:

A Standardised bank has an approximate risk weighting of 37%, as some loans carry a higher risk weight (LVR above 80% and 90%, defaulting loans, non-standard, no LMI etc…).

If the 90% Floor comes in, this would force the 4 Majors to hold 33.3% Risk Weight. This is 8.3% higher than the 25% average Risk Weight allowed by APRA.

Mortgages are different as banks can re-price:

8.3% on 10% capital ratio and 30% current return on regulatory capital across the residential mortgage portfolio suggests banks will raise rates by 0.25% to maintain profitability (8.3% * 10% * 30%) – an equivalent to an RBA rate increase. Banks can do this for variable loans made in the past by adjusting their standard variable rate upwards. New and old loans will have higher interest rates and consumers pay for Basel’s actions, not the banks, if banks choose to pass on the cost and they seem to be very active in doing this.

The major difference here is that banks can re-price their variable rate mortgages. Perhaps corporates are smarter than consumers but one should think that consumers should look for better risk protection and not continually subsidise major bank profits,

So watch out for Basel, especially if your bank can re-price your debt.

Note: Photo of Wayne Byres from Louise Kennerley via smh. 

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Helping Home Owners: Building Better Loan Products

At Huffle, our mission is to help home owners get onto the housing ladder and then have a happier, lower risk way to look after the financial burden that comes with a home loan.

Joining forces with others or having a larger deposit does lower the risk and cost – but what is being done by banks to actually help reduce the risk in the loan product? We think very little and it is a great shame. It isn’t even that difficult to look at what potential answers would be and here is a simple example.

How much can we borrow?

Lenders assess what is called serviceability: can you make all the due payments on a home loan. This is done by looking at your income and expenses and assuming that interest rates will rise 2% or 3% from current levels. This means that lenders will assume an interest rate on a variable mortgage may be as high as 7%. Can you afford to pay this? Obviously 7% interest rates will have higher monthly payments that 4% or 5%, so the total amount you can borrow may not be enough to buy the right home.

Easy solution: Long-Term Fixed Rates

There is a huge shortage of long-term fixed rate home loans in Australia. No lender offers an appropriate product: fixed for long enough so that interest rate increases are not a problem and with the flexibility to leave early if you move home. Compare this to the United States, where 90% of all home loans are of this type: borrowers get a much better deal on the other side of the Pacific.

If your home loan was fixed, say at 5% for 10 years, then you can say that there is only a very small risk of interest rate increases and an assessment on the borrower can be how much can you borrow at just 5% interest rate.

Ignoring the deposit requirement, you can lend between 10% and 25% more if it is long-term fixed rate than a variable rate for the same serviceability assessment. Having a long-term fixed rate reduces borrower risk to interest rate increases, meaning a lender can offer a larger loan.

Screen Shot 2016-12-16 at 11.11.54

What about 2,3 or 5 Year Fixed Rate Home Loans?

This simply isn’t long enough: you will have a mortgage for over 10 years, with the average mortgage taking 17 years to fully pay off. 10 years or longer is the required fixed period so that enough of the mortgage is paid off before you need to refinance to another fixed  or variable rate or move home – and at that point interest rates could be higher or lower.

What if I want to move before year 10?

Simply put – lenders need to offer fixed rate loans without early break fees and with no repayment and refinancing restrictions. Then you can move home with cost or burden and obtain a new fixed rate mortgage.

This would be a real piece of customer innovation and is one of the products we are bringing to Australia. This can help Millennials onto the housing ladder and those already on it that are a little concerned about interest rate increases. 

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Why Fitch Can Be Wrong (Again)

We should think about statements like this:

“[First Time Buyers] considered the highest risk borrower in the [Bank] portfolios”

Few comments on this:

  1. Fitch has been wrong on mortgages in a big way in recent memory, so don’t take everything they say as gospel.
  2. First time buyers usually have much higher loan-to-value ratios than other buyers. Less buffer to absorb loss given default, so if house prices fall there obviously a higher credit risk potential.
  3. Investment property is potentially a higher risk.
  4. First time buyers with higher risk is a product of incredibly poor innovation by banks and a total unwillingness to invest in new lending products that would reduce risks to first time buyers.

Going through these comments:

Fitch has got things wrong before and is probably wrong again:

We are aware of huge miscalculations in mortgage securitisation (e.g US subprime mortgages), of which the assumption of ever increasing house prices led to a misunderstanding of risk.

In the Australian context, the error here is assuming first time buyers are more risky than investment loans. Here is why:

Investment loans, particularly where the investor has high leverage across multiple properties with reasonably high leverage has a risk driven from multiple reasons:

  1. The rental yield doesn’t cover the mortgage finance cost (interest rate). The investor may be reliant on tax deductions and ultimately price appreciation for a positive return. Momentum will eventually slow or reverse.
  2. The correlation across investment properties is high. The investor would be hit with price declines, potential negative equity and further net negative rental yields all at the same time.
  3. Many renters, in a recession, are likely to move to find new work or move in with parents if they lose their jobs. What is worse than negative net rent? No rent or a significantly higher vacancy rate which may be increased by higher apartment supply and an investor’s inability to cover the investment loan.

In short: investment property lending is more risky than lending to first time buyer owner-occupiers who will have a desire to live in the property over the long-term and protect their full recourse debt position.

Banks are not helping or showing any innovation to help first time buyers or those who need to take on additional debt to buy a home.

Australia has the highest OECD exposure to housing debt (home loans) but is 85% financed by variable rate loans. The remaining 15% is short-term fixed (less than 5 years). Banks are not innovating on lending products – and clear overseas examples exist as the US mortgage market is 90% fixed for 15 or more years yet no products exist here. This would reduce the risk to first time buyers proportionally more than other borrowers.

We can also show, this is our business proposal, how it is possible to offer these mortgages products with the correct features and still make 20%-30% return on equity for a bank.

Screen Shot 2016-11-18 at 09.50.42

We can keep writing about housing risks as to whether they will or will not appear but with very little being done about it protecting against the risk. Who is ultimately responsible and who is innovating?

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Australia: The Land of the Undiversified

Researchers from MIT Sloan have come up with new findings that the GFC (2008 Financial Crisis) was not caused by subprime mortgages.

MIT Sloan may be a little late on this one as most major market participants are aware of “Correlation Equals 1” and how the reliance on cheaper short term borrowing and overnight liquidity drove the entire financial system before its near-collapse. Much of this has also been covered with increased liquidity requirements, such as higher reliance on sticky deposit funding and leverage limits via the 3% equity to asset ratio.

This additional regulation has attempted to plug one potential weakness in the financial system. Do other risks exist, particularly in Australia?

Looking more deeply at the construction of assets across Australia, it faces its own “Correlation Equals 1” problem in that the entire economy has gone long on housing, is reliant on variable rate financing (prices can adjust upwards quickly and at a bank’s choosing), has become over-exposed to Australian equities and Australian financial services. We explain this via 3 charts

Chart 1 via OECD: Super Fund Asset Allocation (Shortage of Non-bank Fixed Income)

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Chart 2 via OECD: Household Debt to GDP, Leading Nations (Over-exposure to Mortgage Debt)

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Chart 3 via S&P: Industry Weighting to Financials (Over-weight Financials)

Screen Shot 2016-11-18 at 10.01.01

Australia has created for itself one of the most correlated economies on the globe that could be exposed to deep risk if any of the following happens:

  1. A need to significantly increase interest rates, most likely due to imported inflation
  2. One of the 4 Majors banks comes under pressure
  3. The momentum in house price growth or credit supply slows

Alternatively, 44% (35% Financials + 9% Real Estate) is based mostly on the well-being of the real estate market in Australia. The financial reward from real estate is tied to the ability for the future to pay higher prices, so well functioning financial markets assist this reward and hence lead to the high correlation (from a mathematical risk perspective, there is only really a time delay between the outcomes).

I am less pessimistic on the housing market but a number of products need to be created to reduce the risk to the system and ultimately leave households in much better financial positions.

  1. Where are the Fixed Income Investment Products:

Australian deeply suffers from a lack of high quality non-bank investments that can complement the equity exposure in super fund portfolios. Moving the weighting of Non-Bank Fixed Income asset weighting from 8.8% to 20% will increase portfolio Sharpe ratios, reduce downside risk and may even offer high lifetime returns even in optimistic scenarios (as well as downside scenarios). The ultimate goal is to ensure retirees will be able to cover their retirement needs in as many future economic scenarios as possible.

This is also a fantastic way for the banking industry to diversify its funding sources further, leading to a more secure financial system (note: there would need to be deconsolidation processes to create non-bank exposures).

  1. The housing market needs to move away from variable rate financing:

Over exposure to the RBA cash rate means that the economy is reliant on what the RBA does and how banks pass those movements on (remember, banks can independently change the interest rates on the variable home loans that make up 85% of the house financing in Australia). Short-term fixed rates, such as 2, 3 or 5 years, do protect for a short period but they quickly move to either variable products or borrowers need to find a new fixed rate. Those newly fixed rates could also increase, as happened in Australia in the last few weeks:

If we can achieve these 2 things, we may be on the path to reducing the overall high correlation the Australian economy currently faces.

This is the biggest opportunity in Australian Financial Services and we are working with banks to make this a reality.

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Smart Contracts and Helping First Time Home Owners

One graph should scare everyone: First Time Buyers are being priced out of the Australian housing market. They made up 25% of property buyers in 2009 but this has declined to sit closer to 10%. On top of this, up to 50% Australians get help from their parent to buy their first home (versus just 3% 6 years ago), so technically the pure first time buyer portion is even lower. The Australian property market stakeholders, which includes real estate agents, government, the RBA, retail banks, ASIC and APRA, are underserving our younger generation.

Screen Shot 2016-10-03 at 12.02.28

From an economic stability point of view, we should want the population to have access to being owner-occupiers, particularly as they start to have young families and become the driving power of the workforce.

Why Has First Time Buyer Percentage Declined?

Former Bank of England Governor, Mervyn King, in his book The End of Alchemy wrote about the intergenerational wealth transfer from the young to the old. In short, the global reduction in interest rates – the RBA has reduced interest rates 18 times and 5.75% in the last 10 years, down to an all-time low of 1.5% – is a major contributing factor.

Lower interest rates provide a huge help to those already with debt loads and assets: lower interest rates mean people are able to borrow more and this inflates asset prices. Lower interest rates are also a direct assistance to those paying off mortgages as the cost of debt declines. Mortgages are given out to those able to service them and most importantly have deposits to hand.

Older generations (Baby Boomers) benefitted from selling houses at high prices to mid-life adults (Gen X), who have been helped with lower interest rates. Millennials, unfortunately, then miss out as the house prices increased too quickly and too far. With the required deposit now mostly unattainable and a huge quantum of debt now a major inhibiting factor (Gen X typically has a deposit from their own prior homes and have been upgrading).

With strong price increases driven by lower interest rates, those with property portfolios can access equity in their property to be the deposit for the next house purchase. Investment property owners have the double-whammy of great returns and reduced competition from owner-occupiers.

First-Time Buyer Constraints

Simply, they don’t have access to a deposit to leverage into a new purchase. They need to save a minimum 10% of the house price value. And if they want to buy anything near a major city CBD, that will be something around $50k for a $500k apartment. Want a 3-bed house and the deposit requirement could be north of $100k.

To save the $50k or $100k, assuming aggressive joint household income of $150k (which puts the first time buyers in the top quartile of household incomes), and assuming they are able to save 30% of net income (after rental payments), the deposit could take up to 3 years to build ($100k * 30% = $30k, 3x $30k plus interest/investment gains = $100k). And this is being incredibly aggressive – very few people are lucky enough to “go and get a well paid job” as Joe Hockey said.

However, in those 3 years, house prices have roared further away and the required deposit has increased further, leading to the view of an unattainable dream. First time buyers will need even more deposit when the time comes (in Sydney, it is another 60%, or $30k on the $50k).

How Can Millennials Fight Back? (Hint: By Doing Something Different).

Whilst Gen X may have received a huge boost, technology and communications has been a major benefit to Millennials. Our view is that trying to harness that in the correct way may allow Millennials to fight back and get a footing. Obviously as a consequence, some form of behavioural change may be required.

Our view: They should buy together.

Consider that stage in life where you are renting with 2 or 3 close friends. You are paying away rent whilst still not having certainty on where you will be. You choose to either;

  1. Not buy but pay rent to someone else, or;
  2. Rent-vest (buy an investment property somewhere that is affordable and choose to rent where you want to live).

Neither Of These Options Help:

Not having a stake in property whilst prices roar ahead is an issue and as prices rise, the risk of falling further behind is a problem. Hoping for a correction is another danger – the entire system is set up for price increases and don’t think for a minute that the RBA, the government or APRA really want to take the flack for sinking house prices and risking a recession. Best bet is that they try to manufacture 3% annual price increases but this is difficult.

Rent-vesting has its own problems. In finance speak we would refer to it as basis risk. You have a desire to save towards owning in a popular suburb in Melbourne like Elsternwick but you have invested in Perth or Brisbane where house prices are lower. Your investment property can easily fall (as commodity prices decline) whilst Melbourne prices increase. Buying a CBD apartment to rent is probably the riskiest investment available as huge oversupply is about to arrive.

Fractional Ownership:

This is a recently tabled option. However:

  1. You are not really investing in property and still face that basis/rent-vesting risk
  2. Fractional models can’t get a normal residential mortgage, so the mechanics are completely different. In many ways you are better off buying shares in a real estate business
  3. You will may struggle to sell the fractional ownership and the costs associated with it may be very high

Buying With Friends:

We believe the best option is the simplest and removes costs you are already facing: buy with your housemates.

You are already paying rent – a commitment with friends. Why not go one step further, combine your purchasing power and buy where you want to live. And most likely, if it is in a popular area, the price will appreciate at a better rate than a CBD apartment. This also helps those with unpredictable incomes, such as freelancers.

cohome floor copy

Technology To Make This Easy:

The next steps are to work out the best ways to manage the relationship with your friends and newly made investment partners. Legal contracts and making sure you square off over and under payments you each make is really important. This is what technology can deliver and I certainly don’t think Gen X will be thinking the same thing.

Taking this into the future, the home may no longer become a directly owned asset. People may choose to have their primary residence but have it part owned by other people – either in the form of intergenerational ownership or something owned with friends and rental payments paid on portions of the asset.

This complex web of ownership becomes a necessity as younger generations look to blend ownership with high debt loads that may take longer to pay off. Having sophisticated and secure methods for tracking who owns and owes what becomes a reality for the financial system and a solution that sits on distributed ledgers via smart contracts could be an obvious starting point.

Introducing coHome:

And this is what we have been working on. Our new offering, coHome, enables people a selection of tools to manage buying with friends and family.

We have launched with a small selection of services and will sequentially release more tools as requests come in for those services. We have designed out prototype smart contracts and ledgers but do require mass adoption before we start revealing how we achieve this.

For more information, please visit www.cohome.co

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How Fixed Rate Mortgages Transform Affordability

A previous blog discussed overall housing affordability in Australia. Using a simplified version of serviceability we determined that the median house was only affordable by the top 10 percent (90th percentile) of household incomes (under a set of conservative assumptions). This has been the status quo for a while, with lower interest rates being counteracted by higher house prices.

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Of course, this affordability isn’t broadly true even if it feels like it. We note that many households will resort to interest only mortgages, which reduce the payment burden but do increase the risk overall. Other mechanisms also exist so that a wider portion of the population can still buy the median house.

However, the trend – where the income band increased from top 30% in 1998 to just the top 10% by 2014 is worrying. The trend exists under all circumstances even if the exact percentile brackets are different. The extra risk via interest only and the overall interest risk taken by borrowers in variable rate products is a large systemic risk Australia and the RBA needs to contend with.

Revisiting the model

If we take a 3.75% variable rate and apply it to our last data point, we observe that the top 15% can now afford the average home as the mortgage is more serviceable due to the lower interest payment (note: the house price data is not up to date). Housing gets more affordable based on our conservative affordability assumptions. One would expect an increase in house prices to close up this shift.

Taking the analysis further: what happens to house prices and affordability when our 10-year mortgage is launched?

Further assumptions:

  1. The current expected interest rate for our 10-year is at 4.5% and this is allowed to be applied for the life of the loan.
  2. We are able to deliver our mortgage going backwards using similar observed metrics plus other wholesale pricing observations (we cannot disclose this here, sorry).
  3. Serviceability can then be determined using the interest rate for the fixed rate and not via a 3% upwards stress.

Fixed is lower risk for the borrower

The subtle difference in the serviceability assessment means what the borrower is able to take on as debt is higher for fixed rate (vs. variable) as the borrower has less overall interest rate risk. Alternatively, a borrower can take on the same amount of debt but with lower risk versus a variable loan. Using our assumed mortgage rates, we obtain the following results:

  1. A Principal and Interest Variable Rate Mortgage at 3.75% using the above methodology suggests the median house is affordable to the top 15% of the population (85th percentile).  Note: the house pricing data is on a lag.
  2. For the Fixed Rate home loan, even though it has a higher fixed rate, the affordability is to a wider audience. The top 20% of earners (80th Percentile household income) can afford the median house and historically an additional 5% to 10% of the total population would be able to buy the median house.

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Now a few key pieces to add

  1. Fixed rate debt can be taken on with more confidence knowing the rate cannot increase. Most importantly here, borrowers can have greater confidence in their repayment certainty. The cost is a higher interest rates compared to variable loans.
  2. Lower systemic risk: fixed rate home loans have lower systemic risk as interest rate increases will not impact home owners and damage retail consumption – it will impact the wholesale funding portion of the financial system. In other words, a fixed loan with repayment optionality shifts all of the interest rate risk from the borrower into the financial system.
  3. Housing hasn’t been affordable for a while, however it is more affordable to Fixed Rate borrowers on a consistent basis, meaning a wider set of customers for a similar quantum of risk. It just depends on the method and product the lending is delivered.

Look forward to comments and discussion.

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